Stocks could see new volatility in 2014

With market indexes reaching new heights daily, some strategists say stocks could be heading straight into a buzz saw in 2014.

That's not to say the market will end next year lower, but several say whether it's the Fed tapering its bond buying or some other catalyst, stocks could have a bigger fall next year than the shallow 6 percent decline of earlier this year. And gains may also not be that great—single digits or low teens, versus this year's rich 20 percent-plus gains.

The Dow was trading in record territory Wednesday, after finishing Tuesday at 16,072.8, up 23 percent-year-to-date. The S&P 500 was also hovering at highs after closing at 1,802 Tuesday, and the Nasdaq continued to lift off past 4,000 after closing above that level Tuesday for the first time in 13 years. The Nasdaq is up 33 percent this year, and the small-cap Russell 2000, also at highs, has gained more than 33.5 percent for the year.

This year has frustrated Wall Street's strategists, who repeatedly upped their forecasts as the market zipped higher and higher, ignoring warning signals along the way.

"If the market keeps going up, you probably start increasing the potential to get to a double-digit [decline] but that's speculation on my part," said Tobias Levkovich, chief U.S. equity strategist at Citigroup. "As it stands today, we're looking at 5 to 7 percent, but if the market keeps marching higher on this, I think you're looking at the chance for a higher adjustment."

The market has continued to move higher, even as some analysts say valuations are getting stretched and earnings growth does not appear powerful enough for much more in the way of gains. Levkovich said its liquidity and momentum, not operating performance that's driving stocks higher.

He said one factor was the Fed's decision in September not to begin to wind down bond purchases, when the market had expected it to. That led to further stock market gains.

"A number of people think the market's gone too far. I'm one of them. I think we've borrowed some of 2014's returns into 2013," Levkovich said. He expects to see more volatility in 2014, especially around the timing of the Fed's tapering announcement.

Some Fed watchers believe the Fed could act to slow quantitative easing asset purchases in December, but most see it announcing tapering in January or March.

Strategists say the Fed is not the only factor promising to bring uncertainty to stocks next year, as rates react to Fed policy changes, but it is the biggest.

"The next 12 months is really a story about how the narrative changes and what kind of market we're in," said Thomas Lee, JPMorgan chief U.S. equities strategist. "It's not really sentiment that's important. It's really how the cumulative picture will develop over next year."

He does not have a target yet for 2014 but said the Fed is an important factor.

"There's a scenario if the Fed tapers, nothing may happen, but there's a scenario where the Fed tapers and the market's down 20 percent," Lee said. "It just depends on how comfortable people feel with the Fed action. I think they're comfortable with the Fed taking action if everyone believes the economy is reaching escape velocity."

Levkovich expects the S&P 500 to reach 1,900 by year end 2014, with a 6 percent improvement in corporate profits. The S&P exceeded his target of 1,650, which a year ago was about 100 points higher than the average forecast.

One strategy he likes is to shift focus to large caps from small caps, which have dramatically outperformed.

"You retain your equity exposure but take down risk a little by favoring large over small," Levkovich said, adding that the differentials in price earnings ratios between small and large caps suggest that large caps will start to outperform.

Goldman Sachs equity strategists also forecast the S&P 500 would reach 1900 by the end of 2014. "We estimate a 67 percent probability of a 10 percent drawdown at some point in 2014," Goldman analysts wrote.

Analysts say the mean strategists' forecast for next year is about 1,880 for the S&P 500, which is already well above this year's mean, in the mid-1,700s.

Levkovich said the metrics he follows show contradictory signs but they appear to be pointing to a market pullback. One is the "panic/euphoria model," which went into euphoria. He said when that happens, there is an 83 percent chance the market will be down 12 months later, but other metrics don't show the same thing.

"Today, valuation and credit conditions are quite positive for the markets," he said.

Jeff Kleintop, LPL Financial's chief market strategist, is a bit more bullish. On Monday he forecast a 10 to 15 percent gain in the S&P 500 for next year, based on his expectation that the economy will grow at 3 percent and earnings at 5 percent to 10 percent. He also sees the 10-year yield at 3.25 to 3.75 percent.

Kleintop said there could be volatility if investors worry the Fed has come off the sidelines too soon and the economy is not strong enough.

"The primary risk to our outlook is that better growth in the economy and profits does not develop. That risk is likely to be much more significant than the distractions posed by Fed tapering and mid-term elections," he wrote.